“Warren Buffett once wrote that value investing is like an inoculation--it either takes or it doesn’t--and when you explain to somebody what it is and how it works and why it works and show them the returns, either they get it or they don’t.”
-Seth Klarman of the Baupost Group

Monday, June 15, 2009

Over the last few days the strange love triangle between IPC Holdings (IPCR), Max Capital (MXGL) and Validus Holdings (VR) has gotten even more convoluted. For those of you who have not been following this story, here is a brief timeline of the recent dramatic and even Desperate Housewives-worthy events:

March 2nd, 2009: IPCR and MXGL agreed to combine forces. The original agreement was for the group to maintain the Max Capital name under the following terms:
1. Holders of MXGL shares would receive .6429 shares of IPCR in a tax free, stock for stock merger
2. IPCR shareholders would then control 58% of the combined entity with MXGL shareholders holding the remaining 42%
3. The deal was set to close sometime in the 3rd quarter 2009.

MXGL closed at $16.20 on 3/2 and proceeded to drop all the way down to $14.47 by the end of the day on 3/3. IPCR closed at $24.69 on 3/3 and then also dropped the next day to $22.28. Based on the closing prices at the end of the day on 3/3, the deal valued MXGL at $14.32 per share (.6429* $22.28).

March 31st, 2009: IPCR acknowledged the receipt of an unsolicited letter from VR outlining a proposed transaction. The company stated that it would review the letter but would not comment further until having done so. The offer from VR would have provided 1.2037 VR shares for each share of IPCR. Based on the closing prices on 3/30 the offer valued IPCR at $29.98 (about $1.68B) and offered an 18% premium to the closing price of $25.41. In the letter to IPCR, VR and its advisers highlighted a number of reasons its offer was superior to the MXGL-IPCR tie up, including low leverage ratios, a stable investment portfolio with few investments in “alternative assets”, and a global underwriting platform.

April 7th, 2009: The IPCR board unanimously approved the deal with MXGL and reaffirmed its recommendation that shareholders approve the deal. In the press release IPCR Chairman Ken Hammond stressed the benefits of the deal with MXGL and suggested that the fact that the MXGL would close faster also made it preferable to the VR offer. Also, in a letter to VR Chairman and CEO Ed Noonan, Hammond outlined some additional reasons for rejecting the offer:
1. The VR offer failed to meet IPCR's diversification goals that include moving into less correlated risks
2. The fact that VR's stock price at the time was near the high end of the 52 week range could lead to downside for IPCR shareholders.
3. IPCR was concerned about VR's exposure to catastrophe losses and the subsequent impact on earnings per share and the share price
4. The MXGL deal would have to be rejected by IPCR shareholders before the Board could conduct sufficient due diligence on the VR offer

April 15th, 2009: IPCR and MXGL announced that the Federal Trade Commission and Antitrust Division of the US Department of Justice had reviewed the transaction and granted an early termination of a required waiting period. As a result IPCR stated that the deal should close in June with all the necessary regulatory approvals.

April 30th, 2009: VR decides to take its hostile bid directly to IPCR shareholders after the IPCR Board had rejected the deal. VR also took the occasion to urge IPCR shareholders to reject the MXGL deal.

April 12th, 2009: VR commences an exchange offer for all of the outstanding common shares of IPCR, continuing to offer 1.203 shares of its own stock. At this point VR was trading at $23.68 (on 4/13), implying a $28.49 value for IPCR. IPCR closed on 4/13 at $27.41.

May 18, 2009: After filing an application with the Supreme Court of Bermuda on 5/12 to allow a meeting of IPCR common shareholders, VR increased its offer on 5/18. Under the revised terms, VR offered $3 in cash and 1.1234 shares of VR for each share of IPCR. Based on the closing price of VR on May 15th, the new offer provided IPCR shareholders with $30.14 of compensation for each share, a 13.2% premium to the 5/15 closing price of IPCR and a 21.9% premium to the closing price on 3/30.

May 22nd, 2009: IPCR's Board indicated that it still did not feel VR's offer represented a superior proposal to the MXGL deal. VR then issued a press release stating that it was both surprised and disappointed by that conclusion. Along with re-affirming the belief that its offer provided IPCR shareholders significantly more value than a merger between IPCR and MXGL, VR continued its assault on both IPCR and MXGL for what it deemed as false, inconsistent, and misleading statements regarding its offer.

June 10th, 2009: VR announced that RiskMetrics, an independent proxy voting group, had recommended that IPCR shareholders reject the MXGL merger. Also, VR took this opportunity to revise the deal once again, this time increasing the cash portion to $3.75 per share from $3. The total consideration at this point was $30.36, a 12.5% premium to IPCR's closing price.

June 12th, 2009: After IPCR's shareholders voted down the merger with MXGL, MXGL terminated the agreement for the two companies to merge.

So, after all of the dancing, name calling, and deal revising, where are we today? According to today’s press release from IPCR, after entering into a confidentiality agreement over the weekend, IPCR Chairman Hammond sent VR a letter outlining the necessary criteria for its Board to be willing to consider a tie up with VR. Apparently even after all the acrimony (but only after the MXGL deal got summarily voted down—72% voted against it), IPCR is now willing to enter negotiations with VR.

“We reached out to Validus last Friday, June 12, to discuss terms for a negotiated transaction at a price acceptable to IPC. As the primary consideration offered to IPC shareholders is Validus stock IPC needs to perform due diligence on Validus. Over the weekend, IPC and Validus entered into a confidentiality agreement. IPC provided Validus with our initial due diligence request, retained advisors to assist us in the due diligence process and began work.”

“Even though Validus has twice revised its offer in light of the fact that its stock has dropped 9% since its March 31 offer, Validus’s current offer continues to be at a significant discount to IPC’s book value. Our unaudited book value per share is approximately $35 at the end of May and the implied value of Validus’s present offer as of June 12, 2009 represents a 16% discount to that value. Validus can now expedite the process by negotiating a transaction at a price that adequately reflects IPC’s value. We would require that any negotiated transaction with Validus would give IPC the right to perform a proactive market check between signing and closing.”

Mr. Hammond also indicated in the letter that he expects VR to be willing to pay the $50M break up fee associated with the failed MXGL merger. Not to be outdone, today VR issued a press release indicating its willingness to replace portions of the IPCR Board if it is unwilling to agree to the current offer. The proposal is to solicit IPCR shareholders to call a special meeting in which they could elect three of VR’s nominees to the Board. The nominees include Fuqua Professor Raymond Groth, former Ontario Municipal Employees Retirement System CEO Paul Haggis, and Senior Advisor to Irving Place Capital Partners (formerly Bear Stearns Merchant Banking LLC) Thomas Wajnert.

Ok, you got all of that? Now you ask, since I am not a merger-arb specialist and not a person who speculates on potential deals, why am I interested? The reason IPCR at the current stock price is intriguing to me is based on the quality of the company and not the potential buyout. IPCR is trading at .85x tangible book value despite having $122M in net cash (no debt) on the balance sheet, an attractive 3.15% dividend yield, a consistently low combined ratio, a conservative investment portfolio, and substantial gross redundancies when it comes to loss projections.

Below I have included an updated chart from my original article on the insurers/re-insurers:

Company Name

Ticker

Stock Price

Current P/TBV

2003-2008 AVG. P/TBV

Axis Cap Holdings

AXS

$25.69

0.87x

1.44x

Ace Limited

ACE

$43.77

1.34x

1.95x

Aspen Insurance Holdings

AHL

$22.73

0.72x

1.32x

Allied World Assurance Company

AWH

$39.29

1.00x

1.16x

Endurance Specialty Holdings

ENH

$28.07

0.87x

1.30x

Montpelier Re Holdings

MRH

$13.74

0.84x

1.31x

Everest Re Group

RE

$70.09

0.92x

1.41x

White Mountain Insurance

WTM

$207.01

0.72x

1.51x

Group Average

0.91x

1.42x

IPC Holdings

IPCR

$27.80

0.85x

1.04x

As the chart indicates, IPCR is trading at a discount to the current group average and to its 5 year average price to tangible book. This is despite being the company that I identified as being the best in class out of all of the ones I looked at. I believe the stock has not traded up closer to tangible book value due to the obviously very unpopular proposed merger with Max Capital. Now that the MXGL deal is not weighing on the stock, regardless of what happens with VR, there could be some upside in the near term. However, as always my focus is on the longer term and is the valuation and solid historical performance are the reasons that I would be comfortable owning the stock at the current levels.

My view is that for 85% of tangible book value investors can purchase a very formidable insurance company that will continue to grow book value through its profitable underwriting. Aside from a very bad year in 2005 in which IPCR sustained substantial losses from Hurricane Katrina (an unheard of 251% combined ratio), the company has had a combined ratio that is the envy of many of the firms in the industry. If the past performance is any indication of the way IPCR will perform in non-major catastrophe years, it is hard to argue that the current valuation is justified, especially in comparison to peer valuations. (For those of you who want some more detail on why I believe IPCR is the best in class check out the Scribd document below that includes more extensive charts and data)

In addition, I believe the current valuation gives investors a free call on an accelerated realization of value when it comes to the VR acquisition offer. As it stands right now, with VR trading at $22.52, the deal on the table values IPCR at $29.05 versus the current share price of $27.90. Since it only offer a 4.1% premium to the current price and IPCR management has vehemently stated that it would not agree to be bought out below book value, there is no question VR may be forced to increase its bid once again. Now that the companies are in more formal negotiations, it is possible that they can end the contentious nature of the past discussions and work towards a mutually beneficial agreement. As an example, if VR were to offer Q1 2009 book value of $33.09 (keep in mind that IPCR management indicated that un-audited BV for May 2009 had increased to $35 a share) for each IPCR share, that would imply a 18.6% premium to the current price. Since the companies are already in negotiations and VR continues to make it very obvious that it is interested in a tie up, it would not be a surprise to see a deal agreed upon sooner rather than later. In that event the annualized rate of return based on buying today could be quite substantial.

I would be remiss not to mention that there are some risks here. I happen to believe that the entire market is somewhat overvalued so there is certainly some market risk inherent in shares of IPCR and VR. The good news is that there is an offer for IPCR on the table that could mitigate a fall in the share price. That being said, the fact that the offer includes a large component of VR shares means that the price goes down as shares of VR go down. Also, any deal could fall through due to all of the previous acrimony, combined with the uncertainty in the economy today and the potential that IPCR is looking for too rich a price. Therefore, investors should be prepared for some volatility in the stock price of IPCR in the case negotiations with VR fall apart and should be comfortable owning the shares at this valuation without any expectation of a buyout. Finally, I believe there is some legitimate reason to be concerned about the management team. Obviously the Board badly misjudged the shareholder’s willingness to approve a merger with MXGL and has done a very poor job in evaluating the VR offer seriously. Accordingly, there is no way to be sure that the current Board has the shareholder’s best interests in mind.

In conclusion, while there are a number of risks and uncertainties regarding IPCR right now, it seems to me that the risk-reward profile is pretty attractive for investors with a long-term time horizon or a predisposition to playing the merger-arb game.

5 Best Value Investing Quotes

Seth Klarman: “It turns out that value investing is something that is in your blood. There are people who just don’t have the patience and discipline to do it, and there are people who do. So it leads me to think it’s genetic.”

Seth Klarman: “It sounds kind of crazy, but in times of turmoil in the market, I’ve felt a sort of serenity in knowing that I’ve checked and re-checked my work, one plus one still equals two regardless of where a stock trades right after I buy it.”

Howard Marks (Oaktree Capital): “For forty years I’ve seen the manic-depressive cycle of investor psychology swing crazily: between fear and greed – we all know the refrain – but also between optimism and pessimism, and between credulity and skepticism. In general, following the beliefs of the herd – and swinging with the pendulum – will give you average performance in the long run and can get you killed at the extremes.”

Bruce Greenwald (First Eagle Funds): "There are no bad days in the market. When the market is down, you’ve got bargains, and it’s lovely to think of what you are buying at low prices. When the market is up, the bargains have gone, but you’re rich.”

Mohnish Pabrai (Pabrai Funds): “Warren Buffett has said many times that people either get value investing in five minutes or they won’t get it in five years. So, there is something in the human brain, that for some of us, makes all the difference in the world right away and the patience it requires is part of the wiring process.”